During the bull market of the 1990's and through 2000, employer stock options became the largest component of the compensation for senior executives at public corporations. Also, the availability of stock options became more widespread. In 1992, there were about 1 million employees holding stock option grants. By 2002, that number had grown to almost 10 million employees. Technology companies particularly embraced stock options. In 2000, CISCO employees exercised options for a total gain of $2.5 billion and Enron employees realized $1.5 billion in stock option gains. In Enron's case, the top 200 of 25,000 employees accounted for $1.2 billion or 80% of the total gain.
A stock option is a right to purchase shares of stock at a set price during some period of time. Most often, the option price is the market price at date of grant and the exercise period is a five to ten year window. Most stock option plans discriminate for the benefit of senior management of a corporation. As such, these plans are “nonqualified” for income tax purposes. The Internal Revenue Code has special rules for Incentive Stock Option and Employee Stock Purchase Plan Option plans. While providing opportunities to tax certain option gains as capital gains, generally these plans require that they be non-discriminatory. As a result, the vast majority of stock option grants and exercises are nonqualified plans. As such, the increase in the share value over the option price in the non-qualified plan is ordinary income to the executive at the date of exercise. Also, the employer receives an ordinary income tax deduction equal to the same amount as the employees' income at the date of exercise.
Generally Accepted Accounting Principles (“GAAP”) accounting rules differ from tax rules for stock options. GAAP permits the corporate expense of a stock option grant to be the difference between the current market price and the option price at the date of grant. That difference is normally zero. This is a long standing GAAP rule. Today, the Financial Accounting Standards Board (“FASB”) requires corporations to also disclose the estimated fair value of stock option grants to an employee as determined by a sophisticated financial model (FASB Statements No. 123 and No. 148 specify the Black-Scholes valuation model). This fair value accounting is an accounting method that can be adopted by companies. During 2003, it became apparent that FASB will require some form of Black-Scholes current value expense accounting and soon. In anticipation of this accounting change, during 2003 and 2004 a number of large corporations elected to adopt FASB Statement No. 123 and No. 148 accrual accounting for computing the GAAP cost of stock options. In addition, some companies significantly revised or even eliminated their stock option plans (e.g., Microsoft and IBM). In the past, absent the Black-Scholes model to calculate a present value cost of stock option grants, stock options have had little or no effect on employer earnings. On the other hand, the exercise of stock options by employees does trigger a significant tax deduction without a book earnings charge or penalty. For example, in 2000, Enron reported GAAP earnings of about $1 billion. Because of their $1.5 billion of stock option exercise income tax deduction and other tax shelter items, Enron paid only $63 million in income taxes. That was the first tax paid in five years by Enron despite an average book income of $650 million per annum during the same five year period.
Because of Enron, a number of other high profile corporate failures, and well publicized incidents of executive white collar crime, there is a widespread belief in academia and in Congress that the executive malfeasance during the last decade arose indirectly because of the extraordinary tax benefits of stock options to corporations. GAAP provide no disincentive to counterbalance the opportunity for the privileged few in senior management to use larger and larger stock options to increase their pay. Corporate book earnings were not affected by the grant or the exercise of stock options. The significant tax benefits to the corporation helped to justify the huge and near term wealth created by stock options for senior management. The only apparent consequence was dilution of existing shareholders. With share market value increases in the bull market years, dilution was masked and painless. For too many executives, managing reported income became more important than truly growing their business and earning real revenue—do whatever drives the share price up, became the mantra in the '90s. The consequences have brought scrutiny to the area of benefit plans.